Tax Controversy

On Aug. 12, 2026, the Fifth Circuit withdrew its Jan. 16, 2026, opinion in Sirius Solutions LLLP v. Commissioner, now captioned K Alain, L.L.L.P. v. Commissioner, and issued a revised opinion addressing the limited partner exception to self-employment tax under Section 1402(a)(13). The withdrawn opinion had taken a state law approach, concluding that limited partner status and limited liability were sufficient. The revised opinion instead adopts a functional standard focused on whether the partner plays a significant role in managing or running the business.

The Limited Partner Exception to Self-employment Tax

Sections 1401(a) and 1401(b) impose a tax on the “self-employment income” of every individual. Section 1402 generally includes in an individual’s self-employment income the distributive share of partnership business income or loss described in section 702(a)(8).  Unless an exclusion under sections 1402(a)(1)–(17) applies, the partner’s entire distributive share described in section 702(a)(8) is included in self-employment income.

Section 1402(a)(13) provides one such notable exclusion for a “limited partner, as such.” That section provides that “there shall be excluded the distributive share of any item of income or loss of a limited partner, as such, other than guaranteed payments described in section 707(c) ….” The statute does not define a limited partner, and there is no federal definition of a limited partner.

Over the years, many entities organized formally under state law as limited partnerships (LPs) took the position that this exclusion applied to the entire distributive share allocated to limited partners, regardless of any other facts and circumstances. Additionally, section 1402(a)(13) was originally enacted in 1977, a time before limited liability companies (LLCs), limited liability partnerships (LLPs), and limited liability limited partnerships (LLLPs) were widely used. Because these “new” entity types are now prominent, the applicability of this exclusion to those other entities is significant.

The Tax Court Adopts a Functional Approach

The Tax Court has held that an individual’s status as a limited partner in an LLP must be determined using a functional analysis (Renkemeyer, Campbell & Weaver, LLP v. Comm’r, 136 T.C. 137, 150 (2011)). Notably, the Tax Court further established by reference to the legislative history of section 1402(a)(13) that a limited partner interest “is generally akin to that of a passive investor,” and his allocable share of partnership earnings should be “basically of an investment nature” (Id., at 147-148). Later, the Tax Court clarified on separate occasions that those principles apply to LLCs, as well (Castigliola v. Comm’r, T.C. Memo 2017-62; Hardy v. Comm’r, T.C. Memo 2017-16).

The Fifth Circuit Changes Course

In its revised decision, the Fifth Circuit made clear that it does not accept the IRS’s broad functional view of limited partner status. At the same time, the court moved away from the bright-line state law test it had previously announced. The panel focused instead on the ordinary public meaning of “limited partner,” as it would have existed in 1977 when Section 1402 was enacted. It described it as a partner who plays no significant role in managing or running the business.

The panel also rejected the Tax Court’s formulation in Soroban Capital Partners LP v. Commissioner, which treated limited partners as essentially passive investors for purposes of the exclusion. The Fifth Circuit recognized that a limited partner may have some involvement in the business without losing the benefit of the exclusion, provided that the involvement does not amount to management, control, or a significant role in running the enterprise.

The revised opinion narrows the taxpayer-friendly approach reflected in the withdrawn decision and appears to move closer to the Tax Court’s passive-investor standard, despite claiming to reject it. As a result, the practical difference between the Fifth Circuit’s “no significant role” test and the Tax Court’s approach remains uncertain.

How Much Participation is Too Much?

The IRS had argued in its brief for an en banc hearing that it was never its intention, nor the Tax Court’s, to treat the “most minor involvement” in the partnership’s affairs as exceeding limited partner status. The panel’s opinion does not provide detailed guidance on what level of participation is permissible, or where the line should be drawn between nonmanagerial involvement and a significant role in managing or running the business.

The opinion also leaves broader questions unresolved, including how the analysis should apply to partners in other state law entities that are treated as partnerships for federal tax purposes. Until appellate courts provide additional guidance, taxpayers may continue to face inconsistent standards depending on jurisdiction and entity structure.

The Second Circuit’s Decision in Soroban

On Sept. 17, 2026, the Court of Appeals for the Second Circuit handed the IRS its latest win. The Second Circuit’s decision follows the IRS victory in the Fifth Circuit’s revised opinion of Aug. 12, 2026. Although another similar case in the First Circuit (Denham Capital Management) also remains outstanding, early signs point toward an IRS win in that case, as well.

The Second Circuit ruled on Sept. 17, 2026, that a section 1402(a)(13) limited partner is “… one who has limited liability and who does not run, manage, or otherwise exert control or managerial authority over the partnership” (Soroban Capital Partners LP v. Comm’r, No. 25-2078 (2d Cir. 2026)). The Second Circuit affirmed the Tax Court’s earlier decision that a functional analysis is required to ascertain limited partner status (Soroban Capital Partners LP v. Comm’r, 161 T.C. 310, 325 (2023)).

The Second Circuit Rejects the Passive Investor Test

Although the Tax Court’s primary requirement to perform a functional analysis was sustained, the Second Circuit’s prescribed objectives of that functional analysis are quite different. The Tax Court’s prescribed objectives of the functional analysis were to identify whether a partner was a “passive investor” (161 T.C., at 320-321 (2023)). The Second Circuit effectively overruled the Tax Court’s passive investor test, and substituted a test that instead focuses on running, managing, or otherwise exerting control or managerial authority. Those activities are narrower in scope than the gamut of activities that would be above passive investor status. For example, “actively participating in the partnership’s business” was a type of impermissible activity cited by the Tax Court (see 161 T.C., at 318 (2023)) that is seemingly overbroad under the Second Circuit’s narrower test.

Also, the Second Circuit made it clear that its analysis governs the issue, despite the 1997 proposed regulations; however, the court did not specifically overturn those regulations so the interrelationship between the opinion and the proposed regulations remains an open question outside the Second Circuit.

Comparing the Emerging Judicial Standards

As is now evident, a common theme among the Tax Court and the Second and Fifth Circuits is that section 1402(a)(13) limited partner status requires both limited liability and a functional analysis, regardless of state-law entity type. The Second Circuit remarked in a footnote that there may be “little daylight” between the Tax Court’s and Fifth Circuit’s objectives of that functional analysis. However, it seems clear that there is indeed a significant difference between a passive investor and a partner who goes beyond passive investor status, so long as the partner’s nonpassive activities are not impermissible types. In fact, the Second Circuit acknowledged this outright when it concluded that it agreed with the Fifth Circuit that “some services” are permissible, “[s]o long as the activities in question do not constitute controlling, managing, or running the business …” In a sense, this is actually another similarity between the Second and Fifth Circuits (but not the Tax Court).